stock market question....

[andyandy]

hiya....i'm doing a bit of teach-yourself stock market research from http://www.investopedia.com



Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. Consider a very simple example. Say Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. The futures contract is a promise to buy or sell the stock at a predetermined price. So by purchasing the stock and simultaneously selling the futures contract, you can, without taking on any risk, lock in a $4 gain before transaction and borrowing costs.
http://www.investopedia.com/articles/03/112603.asp


now i cant quite grasp how arbitrage works...i dont get the bit in the example
when they say So by purchasing the stock and simultaneously selling the futures contract, - does this assume that u buy the future at $14 first......and then sell it as u buy the Acme stock? Surely that's just gonna break u even (well...ignoring broker fees....)

help much appreciated - i might even give u some share options....

 

[chriswl]

When they say "sell the futures contract" do they mean you take the other side of the trade. In other words, someone else contracts to buy from you at $14 in six months time. You have already bought the stock to cover the deal at $10 so you can't loose.

 

[andyandy]

got ya!

cheers....ur stocks'll be transfered to ur james randi account

 

[joe87]

You sell the future now, collect $14, and take $10 of that and buy the stock. Selling the future obligates you to provide the purchaser of the future with the stock in six months, so you hold the stock for six months and deliver it on expiration of the future.

However, this is an unrealistic example, because a stock future will usually sell for the current price of the stock plus the interest you would collect if you put the money in an interest-bearing instrument for six months. If the annual interest rate is 6%, for example, the future of a $10 stock will be priced at $10.30, which will net you 3% for tying your money up for six months in the stock.

Edit: oops, too late.

 

[andyandy]

ok cheers joe....i was wondering if it was so simple why everyone didnt just do that

well....seeing as that's kind of finished the thread....it seems a bit of a waste....so how about any other stock market related questions? hot tips? horror storries?

 

[andyandy]

just out of interest how many of you have shares? I've heard it's pretty common in the US for people to invest....over here (Uk) it's generally left to "the suits"

 

[joe87]

just out of interest how many of you have shares? I've heard it's pretty common in the US for people to invest....over here (Uk) it's generally left to "the suits"

According to this source

Stock ownership has been in an upward spiral for most of the last two decades. In 1983, 16 million households owned stock either directly or through retirement plans. Today, that number has grown to 60 million households. More than 91 million Americans own stocks.

And the investor profile puts baby boomers right in the middle of the equity revolution. The Investment Company Institute says the median age of an investor is 51; 70 percent are married and have a job. And median income is $65,000.

Much of this stock market participation is investment in mutual funds in retirement plans (the 401k plans), where money invested is not taxed until it is withdrawn, presumably after retirement. Probably a lot less than half of the 60 million households own individual stocks, but they all have a vested interest in the stock market.

Edit: BTW, the 60 million households represent more than 50% of all households in the US - in 2000 there were 107 million total households.

 

[lenny]

just out of interest how many of you have shares? I've heard it's pretty common in the US for people to invest....over here (Uk) it's generally left to "the suits"

investing in shares, like opening a bank account, is harder in the UK.

but then betting on the stock market is very easy, and the returns are tax free (no income tax, no capital gains, ...)

-las

 

[LazarusLong]

Yikes

I'll give you some helpful advice: Stop reading investopedia.com, delete any bookmarks to it, and forget anything you ever read there. Personally, I've never heard of it before, but based solely on you post, I would hold any information found there highly suspect.

The example given describes the sale of a "futures contract" without specifying whether it is a "call" or a "put", or stating the strike price, or expiration date. All of these things are critical in determining the value of the contract.

If the contract is priced at $14, it must be a put (a contract to sell) as opposed to a call (a contract to buy), since it would be senseless to pay $14 for the right to buy a stock at some future date, when I could buy that stock now for $10. So, we'll assume it's a put, and to make things easier, we'll say it's a very short term expiration, and we can then estimate that the strike price is about $24. That is, when you sell the contract, someone is paying you $14 for the right to sell you a share for $24 anytime before the end of the week (let's say).

- If the price of the stock moves from $10 to $9 and he chooses to exercise his option, he makes money: He's out the $14 he originally paid you, he buys a share on the market for $9 and sells it to you for $24. $1 profit for him. You've paid a total of $34 for two shares, received $14 for the sale of the contract, so your net cost was $20, while your portfolio holds 2 shares at $9 each. You're currently down $2 "on paper".
- If the price moves from $10 to $11, he loses money: the $14 he paid you, the share he buys for $11, and the $24 he gets for selling it to you. $1 loss. Once again, your net cost was $20, but you hold two shares at $11 each, a $2 "paper" gain.

Keep in mind that the buyer of the contract has the option to "exercise" (i.e., sell you his share for $24) at any time within the specified time. You, as the seller of the contract have no say in when, or whether, he decides to do so.

So, back to this nonsense example from investopedia. You buy a share ($10 out), and sell the above-described put ($14 in) and you do indeed have $4 net cash. But you also have a share of stock that they don't mention, which is worth (at the moment) $10. And, even more important, you have an outstanding contract that *may* require you to buy an additional share later for $24. Depending on where the stock price goes, this could very easily consume your temporary cash amount ($4) and more. There is nothing risk-free about this scenario.

So, what is arbitrage, really? It's the opportunity to take advantage of pricing mismatches, and becomes increasingly difficult to do as markets become more interconnected and electronic. To make it simpler to understand, though, just imagine that you have one friend looking to buy a particular bike and willing to pay $200, and another friend wanting to that exact bike for $250. Obviously, you have an opportunity to make a fast $50. While you may hesitate to make a profit at your friends' expense, no one would (or should) think twice about taking that advantage in the invetment world. But there are a few critical requirements which apply to all arbitrage situations, whether it's friends with bikes or globally-traded stock derivatives:

1) There has to be a price differential ("bid" > "ask"), or there's no profit to be made.
2) The friends can't know each other, or at least can't know about their respective bike desire/availability. If they did, they'd find a mutually acceptable price and the spread would be split between them (or in the pocket of the better negotiator).
3) You have to recognize the situation and act on it before anyone else.

For the most part, the prices of modern investment vehicles are widely available to all interested parties in real time, so no arbitrage is possible; any interested seller can always find the highest bidder at any moment. Therefore, modern arbitrage is limited to the more esoteric niches, and requires computer-controlled trading to capture split-second gaps in volatile markets.

Does that help?

-Laz

 

[joe87]

The example given describes the sale of a "futures contract" without specifying whether it is a "call" or a "put", or stating the strike price, or expiration date. All of these things are critical in determining the value of the contract.

They didn't say it was a stock option, they said it was a single stock future. There is a difference. Puts and calls are options, not futures.

 

[andyandy]

yeah - thanks

in defense of http://www.investopedia.com it does go into quite a lot more detail in later tutorials.....im currently in what is effectively the romper room it's got a stock market simulator to play on as well...which is fun
if u can recommend any good internet sources/books for beginners for general stock market investing (low level....) that would be cool.....

 

[joe87]

Actually, Investopedia.com seems to be a pretty good source, based on my cursory look at it. There must be millions of stock market sources on the internet, it's pretty hard to pick out a few. Also, my experience is with the US markets, and the UK markets may be a bit different. This is especially true of the derivatives markets, such as options and futures.

And, it depends on what you plan to do in the market. My experience is mostly as a trader, not a long-term investor except in IRA and 401k accounts. As a long-term investment vehicle, broad-based mutual funds are probably more suitable than individual stocks (less risky). Dollar cost averaging is a good way to build up a nest egg if you have a regular income and can afford to invest each month. I can tell you from experience that trading (as opposed to investing) in the financial markets is a risky business, and shouldn't be attempted with a significant amount of money until you are sure you know all you need to about it.

 

[LazarusLong]

I stand corrected.

I stand corrected. They said "futures", not "options". Their example still sucks.

As a previous poster noted, a contract price of $14 is grossly unrealistic. The buyer of the contract is agreeing to pay the strike price after one year, so his eventual total cost is the strike price plus the contract price; it makes no sense to agree to pay more for a stock in a year than it would cost you today. Therefore, you'd never get more for the contract that you paid for the stock, which is the source of their supposed "risk-free" gain.

I stand by my explanation of arbitrage.

-Laz

 

[LazarusLong]

And also....

OK, I'll relent in my rash condemnation of investopedia.org; I know nothing about it and have not visited it.

Nevertheless, I stand by my criticism of the particular example presented. I don't believe it describes the concept of arbitrage as it is normally used, which is the momentary exploitation of price differentials. Their example involves a contract that is still open after the trade, so there is inherent risk, even if it is only opportunity cost. Arbritrage can indeed make use of futures contracts and options, but they are bought in sold in mutually canceling combinations so that all positions are quickly closed, and only the net cash remains. As long as contracts remain open, there's no way to determine the ultimate net effect.

-Laz

 

[joe87]

As a previous poster noted, a contract price of $14 is grossly unrealistic. The buyer of the contract is agreeing to pay the strike price after one year, so his eventual total cost is the strike price plus the contract price; it makes no sense to agree to pay more for a stock in a year than it would cost you today. Therefore, you'd never get more for the contract that you paid for the stock, which is the source of their supposed "risk-free" gain.

There is no "strike price" associated with a US futures contract. The term applies only to options. If you look at any financial newspaper you will see that futures prices tend to be higher than the current price of the underlying security (the "spot" price), and the farther away in time the expiration date is, the higher the futures price will be. This is known as a contango situation. Only rarely is the price of a futures contract below that of the underlying, (i.e., backwardation) and this occurrs when most participants in that market expect a large price decline in the near future.

BTW, after looking at the investopedia definition of contango and backwardation, I retract my previous statement that they looked like a good source. Google, Wikipedia, and investorwords usually are good places to start to find the definition of terms.

Most people buying a futures contract believe that the price will rise between the time they buy it and expiration, thereby allowing them to profit. They buy futures instead of the underlying vehicle because the futures contract can typically be bought with a small amount of money, say 5% of the value of the underlying. This leverage greatly inhances the profit potential of a price change, but it also greatly increased the risk.

 

[Antiquehunter]

Arbitrage - I can provide you an example in sports betting...

Lets say I find at the Stardust sportsbook Seattle to beat the 49ers by 6 points paying -110 (which means that I need to bet $110 to win $100)

At Ceasar's Palace I find Seattle to beat the 49ers by 8 points paying the same.

So - I bet $110 for Seattle to win (-6) at Stardust, and $110 49ers to win at Ceasar's (+8).

Possible outcomes:

Seattle wins by more than 8 - I receive $210 for my $220 in bets. (Lose $10)
Seattle wins by exactly 8 points - I win one bet and 'tie' the other. So my net return is +$100
Seattle wins by exactly 7 points - I win BOTH bets (because I had 8 points working for th 49ers) therefore I net +$200
Seattle wins by exactly 6 points - I win one and 'tie' the other - net return is +$100
Seattle wins by 5 or less, or any 49'ers win - I win one and lose the other, net return is -$10

Examples like this DO come up (rarely) and professional gamblers can earn their annual salaries from these types of bets. As you can see, I am ensuring my loss is minimal, but my potential for gain is very high. If you could get enough 'action' on these two bets, your potential for a big score is huge, and your losses are minimized. Say you had $11k going each way - the most you could possibly lose is $1000 (less than 5%), but two (very plausible) results gets approx. 50% gains and one (plausible) result gets close to 100% return. You don't need many of these bets to come in to show a steady, long-term profit. Very strong positive expected value.

In the stock market / futures market - there are other examples, but to exploit them you generally need to be very well-capitalized.

You could hold 100 shares of QQQQ (the Nasdaq 'basket' stock) that you buy today for $42 each, and take out a future contract to sell 100 QQQQ (known as a 'put') at $47 anytime between now and January 2007. The contract would cost about $500 to buy, but would help to assure a (small) net gain. Possible outcomes:

QQQQ goes ABOVE $47 - you tear up your contract and don't execute it, losing the $500 you paid for the contract - but you sell your QQQQ for a profit.

QQQQ goes to EXACTLY $47 - the contract is a wash, but you still have your QQQQ profit, minus your costs for buying the contract. You would probably actually have a small net loss in this case.

QQQQ doesn't go above $47 but is higher than $42 - you execute your contract - since you are now making money selling QQQQ at $47, and you can also choose to lock in your profit by selling your QQQQ shares.

QQQQ stays flat at $42 - you have money made in your contract and your shares are a wash - you can continue to hold them or sell them.

QQQQ drops below $42 - you make good money on your contract, but you're losing money on your stocks you own. You can sell out your position for a small profit.

In this example, there is no 'guarantee' of making money, but you have built a 'band' of possible outcomes that cumulatively are more likely to show a (small) profit, and have mitigated the possibility of a major loss in the event QQQQ goes in the tank. However, you are also giving up some of your potential for a major gain. Also, for the small investor, playing as we are in this case with about $5000, the commissions you would pay for buying/selling the shares and the options would represent a major portion of your potential gain here. Arbitrage plays like this generally require major chunks of capital (hedge funds) to make serious money. Finally, as a small investor, you may want to consider that when calculating everything out, you may have better potential putting your money into a good income stock or bond - since the returns you can get there probably compare favorably (with a not-dissimilar degree of risk) with the more complex arbitrage return you can expect.

-AH.

 

[drkitten]

As a previous poster noted, a contract price of $14 is grossly unrealistic.

Most tutorial examples are grossly unrealistic, because exaggerated situations are typically easier for the novice to grasp.

The amount of money I've made on the blackboard selling "widgets" would probably amount to trilions of dollars. But my students tend to pass the final, which is the important thing.

And the whole point of arbitrage is this kind of apparently unrealistic price differential (albeit not to that scale). A simple and well-understood example of is currency arbitrage. If one can buy a single quatloo for ten credits, one would expect that one quatloo would buy ten credits. If one quatloo can buy 10.1 credits, you can make a quick one percent on your credits by buying and and selling quatloos.

But this is exactly how currency traders make their money. A British pound might buy more dollars in New York than the same pound sells for in Hong Kong, so if you have enough pounds and can move them quickly enough around the world, you can make substantial money for a short period of time.....

 

[Antiquehunter]

What is your current buy/sell spread on the quatloo, Dr? I couldn't find it at www.oanda.com

 

[drkitten]

What is your current buy/sell spread on the quatloo, Dr? I couldn't find it at www.oanda.com

You may need a better broker. I use Beaver, Beaver, Beaver, and Faun, of Cair Paravel, Narnia. I used to use Quinbus Flestrin, of Lilliput, but my account got too big for him to handle.

Oh, and my current buy/sell spread? 0.04 + 0.38i. Like most tutorial examples, it has both real and imaginary parts....

 

[aargh57]

OK, here's a shot in the dark. What would anyone suggest to someone that really wanted to learn about investing. When I go to the bookstore there are tons of books all promising to make me a millionaire if I only read their book. Any suggestions? If it matters any, I currently have a decent sized IRA, 401K (in my 401K I can self allocate 20% of my money, the rest has to be in the funds that are offered), and a variable life policy.